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The Riskiest Dividend Stocks

Beware: Some dividends might look alike, but they can be very different.

As my colleague James Early has noted, a full 97% of the market's return between 1871 and 2003 came from reinvesting dividends.

How can that be?Imagine a sideways market -- the kind of market in which stocks of even the best companies stagnate.

A company that doesn't pay you a dividend will just ... sit there. But a company that does pay you a dividend will keep providing you with new investment capital each and every quarter.

In other words, whether the market is good, bad, or indifferent, those dividends will provide you either with regular income or a kind of automatic dollar-cost averaging as you reinvest them and buy new shares quarter after quarter.

But they aren't perfectThe sad truth is that you can go wrong with dividend-paying stocks. They aren't all created equal, and some are riskier than others.

Payout ratios can signal a dividend's stability. If a company's payout ratio -- the percentage of its earnings that it pays out in dividends -- is high, it suggests that the company doesn't have much wiggle room if they're planning to keep the dividend. And as we've seen lately, any unexpected situation can send that dividend straight to the chopping block.

A history of cutting dividends also doesn't suggest future dividend stability. Dow Chemical, for example, may seem attractive, with a dividend yield recently topping 4%. But that yield used to be greater than 15%. Are Dow and its dividend out of the woods? Considering that its payout ratio remains above 100%, I doubt it.

High debt levels can also destabilize a dividend, because when push comes to shove, paying off debt is more important than paying out dividends. Yum! Brands, for example, sports a seemingly reasonable payout ratio of just 38%. But check out its balance sheet, and you'll find cash and cash equivalents of $289 million, along with long-term debt topping $3 billion. Yum! might be able to manage both dividends and debt right now -- but that won't necessarily remain true if the economy continues to dive.

Even dividends that look stable now may not be long for this world. Before you invest in any dividend payer, consider the health and security of the company, rather than being blinded by the lure of a tempting payout.

Screening for qualityYou always want to buy excellent companies with strong growth prospects and good competitive positions -- but even blue-chip dividend payers can sport worrisome signs and risky behavior.

The following companies popped up when I screened for large-cap stocks with dividend yields above 3% and payout ratios above 90% -- an admittedly steep figure. Many investors avoid companies paying out 70% or more.

When a company -- even a great company -- sports payout ratios like these, you'll want to dig deeper to find out why. Is the company fending off a temporary problem, or dealing with something much more lasting? If you're not confident of a company's ability to pay its dividends, avoid those names.

Good, better, bestEven companies with good payout ratios aren't all created equal. Yes, we want companies with safe dividends -- but we also want companies with growing dividends.

Two companies may have seemingly identical dividend yields, but if one has a history of hiking its payout significantly and frequently, and the other doesn't, the former suddenly becomes far more attractive. These companies recently had similar yields, but very different histories:

Company

Dividend yield

5-yr. avg. div. growth rate

MetLife(NYSE:MET)

2.6%

20%

Sherwin-Williams

2.4%

18%

Raytheon(NYSE:RTN)

2.6%

7%

Wyeth(NYSE:WYE)

2.8%

5%

Data from DividendInvestor.com.

To see why this matters, just imagine buying $10,000 of stock with a 3.5% dividend yield. In the first year, you'll get $350. If that dividend grows by 4% per year for 20 years, it will ultimately amount to a $767 annual payout. But if it grows by 12%, it will become a $3,375 annual payout -- almost five times more, and more than 30% of your original investment.

What to do right nowThe riskiest dividend is one that you can't count on. So, pick your dividend payers carefully -- but do pick some, because our downtrodden market currently offers some exceptionally strong yields.

The following candidates that surfaced when I screened for large caps with yields of 2.5% or more, five-year dividend growth rates of 10% or more, and five-year revenue growth rates of 10% or more:

Company

Dividend yield

5-yr div. growth

5-yr. rev. growth

Novartis(NYSE:NVS)

4.6%

15%

11%

CNOOC(NYSE:CEO)

4.2%

23%

25%

MarathonOil

3.1%

16%

14%

General Dynamics

2.8%

16%

12%

Data from DividendInvestor.com and Capital IQ, a division of Standard & Poor's.

Any screen like this is merely the first step toward further research, but these candidates may be a good place to start.

Strong, growing, and stable dividend payers are what we look for at our Motley Fool Income Investor investment service. Try it free for 30 days, and you'll be able to access all past issues and all recommendations. On average, its picks are beating the market handily and boast an average dividend yield of more than 5%. Just click here to get started.

This article was originally published on April 6, 2009. It has been updated.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian